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Monthly Archives: August 2016

Of all the financial concepts applied to investing, there is none more important than the time value of money. Quite simply, this means that the longer a dollar is invested, the more it is worth. That is why it is so important to start investing as early as possible. In fact, the difference between starting at 25 and starting at 40 can mean hundreds of percent in additional returns. Let’s look at the main concept that drives this concept, called the compounding effect of money.

The compounding effect of money refers to the rate at which invested money grows. Whereas, a linear rate would increase each year by the same amount, a compounding rate grows by a larger amount each year because of the return on both the initial investment as well as the return on previous years’ investments. Let’s look at some examples.

First, to illustrate how compounding works, let’s look at what happens to $1,000 that is invested at a 10% rate. In year one, the investment grows from $1,000 to $1,100, or by $100. However, in year two, the investment has already grown to $1,100 and it grows by another 10%, or $110 ($1,100 x 10%). In effect, you have earned $110, or 10% more in year two than in year one. In year ten, the initial investment has grown to $2,593 and is growing by $235 per year. As you can see, each year your initial investment will grow faster and faster in terms of dollars. By investing early, your investment has more years to grow and after twenty five years, you will earn as much each year as your initial investment was worth.

Now let’s look at how this affects two different investors. Let’s say Investor A starts investing at 25 years old and invests $200 per month, earning a 10% return. Now, let’s compare this to Investor B who started investing $200 per month at 40 years old. When both investors are 60 years old, Investor A will have amassed $760,000. However, Investor B will have only saved $150,000. Even if Investor B had made double investments of $400 per month, the savings at 60 would only be $300,000, or still less than half of what Investor A saved by starting 15 years earlier.

As the example above clearly illustrates, the key to investing and saving substantial money lies in the amount of time that your investments have to grow. Starting your investing early is also important because it adds to your financial discipline and makes investing part of your routine. Investors that procrastinate are much less likely to reach their financial goals.